Ruchir Sharma: How Emerging Markets Lost Their Mojo

Ruchir Sharma: How Emerging Markets Lost Their Mojo

Investors have once again come to see state companies as slow-witted giants, prone to overinvest and overbuild.

·                     RUCHIR SHARMA

Emerging economies have lost nearly $2 trillion in stock-market value since the global financial crisis hit in late 2007. The full blame for this meltdown, and then some, can be placed at the door of their state-owned companies, which account for a third of these economies' roughly $9 trillion market capitalization.

Over the past five years, the value of private companies in emerging economies—including Brazil, Russia, India and China, as well as Mexico, Indonesia and Turkey—has remained broadly stable. Meanwhile, the value of state-owned companies (defined here as companies with a government ownership stake of at least 30%) dropped by more than 40%. Today there is only one state company (PetroChina) among the 10 most valuable companies in the world, down from five in 2008.

These losses suggest that the global markets don't buy the conventional wisdom of the postcrisis years when magazine covers heralded "The Rise of State Capitalism" and books forecast "The End of the Free Market." Most of these forecasts started with China, which responded to the growing financial crisis by pushing state-owned banks to lend to priority industries at cheap rates. Beijing also directed state-owned firms to lend and invest aggressively, and otherwise expand state control over the corporate sector.

When China escaped the global recession relatively unscathed, it emboldened governments in emerging markets from Russia to Brazil to follow the Chinese example, and many are still promoting state capitalism. They may be forced to reconsider. Investors have been voting with their money and exiting their markets. But it isn't only stock prices that are in decline. Lower profits for state-owned companies mean less money for the government and lower productivity growth for the broader economy.

During the mid-2000s, a rising tide of liquidity was flowing out of the U.S. and Europe, and investors began indiscriminately bidding up the stock prices of emerging-market companies, private and state-owned. Betting that rising demand from China would continue to drive up prices for industrial commodities, investors poured money into any company involved in energy or raw materials—industries often controlled by the government in the emerging world.

All this changed after the crisis. Investors refocused on profitability, and they have once again come to see state companies as slow-witted giants, prone to overinvest and overbuild. According to our research at Morgan Stanley Investment Management, investors now value government-run companies at about half the price of private firms in the same industry, from banking to telecoms.

World-wide, investors are also shifting money to technology from commodities. This helps to explain why the U.S.—a center of tech innovation—now accounts for nine of the 10 most valuable companies in the world. Meanwhile, state-owned companies in the emerging world aren't being able to keep pace. Technological innovation has never been a forte of bureaucrats.

Not so long ago many governments in the emerging world also saw state companies as sluggish behemoths, burdening their economies. In the 1990s, many began selling off companies they owned, hoping that private ownership would raise corporate profitability and national productivity—and often it worked. In China, reform of state-owned enterprises helped sustain the "economic miracle" there with the government laying off millions of inefficient workers and bringing in more professional management to help run some of its largest companies.

By the following decade, however, the privatization craze was over, discredited by botched attempts in nations such as Russia, where privatization turned into a fire-sale of valuable state assets to rich oligarchs. Meanwhile, the runaway boom in emerging markets was making growth look easy for state and private companies alike.

Now, with investment flowing out, emerging nations need to return to the path of reform, including privatization and reduced government control over the economy. In the past few years, the profitability of state companies has also been slipping, and now revenue growth is falling fast. Interestingly, China appears to be leading the way in recognizing the need for change.

Since taking office in March, Chinese Premier Li Keqiang has been talking about the need for a "self-imposed" revolution to reduce his government's power and promote "market mechanisms" for growth. In the West, many commentators still marvel at how China appeared to dodge the global recession by implementing a huge half-trillion dollar stimulus program in 2009. But in China the evolving view is that the funds were misdirected to wasteful projects like unneeded steel and aluminum plants. The state-run Xinhua News Agency has even been running editorials about how another stimulus would be self-defeating.

Clearly, China's leadership recognizes that its state enterprises failed to make productive use of the surge in government-directed bank lending after 2009. Indeed, according to my firm's research, since then the return on equity of those enterprises has fallen to below 6% from 10%.

To get their mojo back, governments in emerging markets would do well to also count the mounting costs of state capitalism and start cutting back the role of the state, and putting more of their state-owned companies in private hands. Otherwise, these companies will keep destroying wealth, and undermining the economic growth prospects of emerging nations.

Mr. Sharma is head of emerging markets at Morgan Stanley Investment Management and author of "Breakout Nations: In Pursuit of the Next Economic Miracles" (Norton, 2012).